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3M has more where that came from

Jim Mone/The Associated Press

Josh Peters and Adam Fleck are analysts at Morningstar DividendInvestor

Although 3M sells thousands of products to disparate end markets, only a few dozen technological pillars support its wide array of offerings. The company's ability to innovate new pillars and leverage the technology across multiple industries forms the backbone of its historical success.

Recent economic headwinds challenged this profitability because of inherent operating leverage, but we think 3M handled the 2008-09 recession admirably.

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Chief executive George Buckley hopes to use the firm's strong cash flow to pursue acquisition opportunities. Since his arrival in 2005, 3M has spent about 4 per cent of sales per year to purchase outside companies, versus only 3 per cent the five years prior. We think the company's lofty returns justify continued merger spending.

Furthermore, Buckley's engineering background-he holds a Ph.D. in the subject-has reinvigorated 3M's innovation core. The company's vitality index-the percentage of sales stemming from products introduced during the previous five years-has climbed to nearly 30 per cent from the low 20s just a few years ago.

To continue stimulating internal growth, we think that 3M will focus on international opportunities. In 2009, non-US sales constituted 63 per cent of the company's revenue, a substantial increase from 53 per cent in 2000 and up from 61 per cent in 2006. By 2011, we expect the company to generate more than 65 per cent of its sales from international locations.

Similarly, we forecast that during the same time frame, more than 75 per cent of the company's operating profit will stem from international sources because of especially high margins in Asia and Latin America.

We like the growth prospects for 3M's net income, which we think can rise at a 7 per cent to 8 per cent average annual clip over the next five years. To the extent that excess cash flows are devoted toward share buybacks or reasonably priced acquisitions, the rate of per-share earnings growth could approach 10 per cent.

But while 3M has raised its dividend in each of the past 53 years-a remarkable achievement-its current dividend policy means to raise the dividend by only half of the rate of increase to earnings per share on an annual basis. Since 2006, the dividend rate has risen an average of only 3.4 per cent annually, and the average increase of the past 15 years has been only 5.5 per cent-a mediocre record for a stock that currently yields just 2.4 per cent.

A dividend payout ratio of 37 per cent funded from a collection of businesses with competitive advantages and healthy free cash flows, a debt/capital ratio that has stayed around 30 per cent, and a Morningstar credit rating of AA allow 3M to continue its current dividend policy with ease.

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We believe 3M would be fairly valued at $100 (U.S.) a share, which represents approximately 10 per cent upside from the stock's recent price. [Shares jumped 1.5% to nearly $91 in Tuesday's after-hours trading after the company boosted its quarterly dividend by 5% to 55 cents a share and authorized a $7 billion share buyback-Editor.]

However, with 3M continuing to restrain the growth of its dividend payments relative to earnings, we don't expect the dividend to be a prime driver of future total returns.

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